Mba 610 Managerial Economics Energy Gel Case

Strategic Fit of Gels. In 1998 HPC invested $7.5 million in new mixing equipment for its energy bar product line; this machine was expected to have a useful life of 10 years with no salvage value (Raviv, 2007, p. 3, footnote 6). To depreciate/budget, we determined the actual cost of owning the machinery for 10 years. Our purchase price was not $7.5 million, but was closer to $6.2 million; the remaining $1.3 million consisted of maintenance and operating expenses such as oil/lubrication, training/safety, power/electricity, etc. These maintenance and operational costs reduce workplace hazards and provide safer working conditions; they also ensure a profitable future for HPC by assuring consistent production of inventory.

Currently in the year 2000, our manufacturing equipment runs at approximately 60 percent of its capacity or 43.3 million energy bar units; in a perfect world we would operate at 100 percent of our capacity which is 66 million energy bar units; (Raviv, 2007, p. 3). In 1998, HPC did not budget for 10, 40, or even 60 percent of usage when business is slow (low operating cost), they budgeted for 100 percent of usage when business is good (high operating cost). If they had not budgeted for 100 percent of capacity usage we could have been short during times of prosperity.

Profit Potential. Wickler believes HPC is committing a hidden-cost fallacy by underusing the energy bar mixing machine whose opportunity cost is being ignored (Froeb, Brian, Shor, & Ward, 2016, p. 34). Fortunately, Wickler has uncovered similarities in both the Energy Gel and Quickpro energy bars’ manufacturing processes; he believes Energy Gels could be produced on the existing machinery in approximately half the time of an average energy bar (Raviv, 2007, p. 3). The existing machine could easily absorb the necessary production volume for energy gels (Raviv, 2007, p. 3, footnote 7). A $1.5 million investment is needed to modify the existing buildings, and a $2 million investment is needed to acquire packaging machinery (Raviv, 2007, p. 4). But any costs associated with usage of existing excess capacity of the mixing devices is irrelevant, and should not be included in the evaluation. If HPC allows Energy gel to utilize the machinery’s extra capacity, they will not lose 40 percent because they have already paid for 40 percent. The idle 40 percent is an opportunity cost (Froeb, Brian, Shor, & Ward, 2016, p. 32). Wickler’s plan covers our initial research/development and marketing expenses in the first year, and produces 9 straight years of substantial profit (please see Exhibit 1 below). As demand for our units rise each year, the gap between our sales and cost of goods sold widens from 5.7 million (15.0 – 9.3) in 2002 to 12.4 million (31.8 – 19.4) by 2010; this gap represents the potential productivity of our Energy Gel division.

Exhibit 2.

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*Research and development estimated expenditures for the remaining product tests at approximately $250,000 over and above the $2.25 million already invested (Raviv, 2007, p. 3)

**The tax code helps soften the blow from corporate losses; corporations pay income taxes on their profits, not their losses (Merritt, 2017, para. 3). HPC has negative earnings in 2001, so it is exempt from paying taxes.

Economies of Scope. The product manager of Quickpro energy bars, Mark Leiter, believes the Energy Gel division/project should compensate him for utilizing the unused capacity of the mixing machine. Leiter views Wickler’s Energy Gel plan as compromising company assets; he would like the Energy Gel project to be evaluated as a stand-alone business responsible for all investments and costs (Raviv, 2007, p. 5). The corporate controller, Frank Nanzen, also believes the excess capacity of the mixing machine should not be provided for free; he suggests that Leiter rents outs the machine to Wickler and receives a transfer payment (Raviv, 2007, p. 6). Nanzen, however, does not see a need to purchase additional facilities for the Energy Gel product. Both employees do believe that in addition to reimbursement for using the mixing machine, the Energy Gel project should also account for any increase in overhead costs. Leiter emphasized that he did not want to pay for the general/administrative expenses and selling expenses that accompany Wickler’s utilization of the mixing machine. He expected Energy Gel’s general and admin expenses to equal 12 percent of the energy bar’s general and admin expenses in 2001, and grow at 8 percent per year moving forward (Raviv, 2007, p. 6)

If I did not believe in Wickler direct costing basis and instead suggested Leiter’s stand-alone business approach, HPC would need to invest $3 million in new mixing equipment while our current mixing machines full capacity remained unused (Raviv, 2007, p. 4). This mixing equipment would not be ready for 2 more additional years, putting HPC 6 years as opposed to the current 4 years behind in entering the lucrative energy gel market. In addition to waiting 2 years to produce a product that consumers are ready to purchase today, HPC could only utilize 25 percent of capacity in the first year of full-time production (Raviv, 2007, p. 5). This would continue HPC’s history of committing hidden cost fallacies by underusing our mixing machines who opportunity cost is being ignored. HPC will instead prosper by using the full capacity of machines that are already purchased; this logic will result in a payback and ROIC exceeding the necessary 7 years and 15 percent (Raviv, 2007, p. 5).

Sensitivity Analysis. I mentioned before that in 1998 HPC invested $7.5 million in a new mixing machine. I then explained how HPC budgeted/depreciated the asset at 100 percent usage capacity identical to industry standards. Within this budget a business structure and plan were devised; one that allocated enough funds to Leiter and his team to operate the energy bar division at 100 percent of capacity. Unfortunately, in 2000 the machine operated poorly at 60 percent of its capacity, which signals an inefficient use of space, equipment, and staffing (Keolanui, 2016, para. 3). When HPC’s production capacity is idle it is not generating any income; since additional production volume does not increase fixed costs, higher capacity utilization results in lower per-unit product costs and higher potential profits (Nyitray, 2014, para. 2). Therefore, we will use Wickler’s direct cost basis approach to the Energy Gel project to profitably utilize the unused capacity of our current mixing equipment. Leiter and his team will not receive a transfer payment for the use of the current